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From the oil well to the CPI: How the rise in crude prices is shifted

  The price of oil has doubled in the past year and a half to reach an all-time high level, thus presenting an economic shock in supply comparable to those seen in the Seventies. Nevertheless, as opposed to those at that time, the impact on inflation has been very moderate.

  The first impact from the rise in oil prices is seen on fuels. Variations in crude oil prices are rapidly shifted to prices at the service station pumps although in overall terms exchange rates may have an influence, given that crude oil prices are quoted in dollars. According to a recent study by the European Central Bank, this shift normally takes place within one or two weeks in the euro area. As a result, the sharp increases in oil in recent months would be reflected in fuel (petrol and diesel-oil) indices. Nevertheless, these increases are influenced by the effect of special taxes placed on fuels. In fact, as these taxes involve a fixed amount per litre, the percentage increase on a litre of fuel is lower than the increase in oil and fuels before taxes.

  In fact, the amount of tax on a litre of fuel varies greatly from country to country although in the European Union there is some harmonization. In the United States total tax on fuels make up around 20% of the price to the customer whereas in the United Kingdom this rises to close to 65% (see accompanying table). As a result, changes in the fuel index in the United States are usually sharper than in Europe. For example, the year-to-year change rate in USA for this figure in August was 31.3% compared with 12.3% in the European Union (EU-15).

  On the other hand, the weighting of costs related to oil in the consumer price index is low. In the European Union (EU-15) it amounts to 4.4%, including motor vehicle fuel and heating fuel whereas in the United States it is 4.3%. As a result, it is not so strange that consumer price indices are not raised very much by this factor, although it has affected the general US index more. In fact, the sharp rise in fuel prices has had an impact on other components. Core inflation (the most stable part of inflation) stands at 2.2% in the United States and 1.4% in the EU-15.

  But as well as direct effects there are indirect effects. In fact, in the first place, the increase in oil prices involves a rise in cost of inputs for chemical companies and other manufacturing companies and in transportation. If the increase in costs is not absorbed by corporate margins and must be reflected in prices other sectors find their production costs increased. As a result, the initial effect may be shifted right across the economy. On the other hand, workers who see their purchasing power reduced may wish to recover it through wage increases to compensate this loss. In this way, all this may begin a price-wage spiral resulting in an increase in inflation.

  Up to now, these effects, called «second round effects», have not occurred in the main developed countries. This is due to a number of reasons. On the one hand, oil dependence is now much lower than in the Seventies while at the same time energy intensity has diminished, measured as the amount of energy per unit of gross domestic product, given that the importance of services has increased to the detriment of industry. In addition, markets for factors and goods and services have been more liberalized and deregulated. In recent years, many indexing mechanisms have disappeared although they still exist in some countries. In Belgium, Luxembourg and Spain, wages in most sectors are indexed. At the same time, in contrast to the first shock in the Seventies, the economies are not over-heated and, in the case of the European Union, the economy stands considerably lower than its potential level (the level which ensures sustainable growth without inflation).

  Furthermore, and no less important, the central banks have gained credibility following decades of fighting against inflation, so that prospects regarding future inflation appear to be contained. In fact, the increase in oil prices represents a loss of real national income in favour of the net oil exporting countries, given that the trade relation is deteriorating as prices of imports increase relatively more than those of exports. This inevitable loss of income may set off inflation if all economic operators try to shift this decrease in real income to other agents.

  In the current oil crisis it is important to avoid the errors of economic policy made in the first oil shocks in the Seventies, given that monetary and fiscal policies of too lax a nature brought about a situation of «stagflation» with an increase in inflation and unemployment. Because of this, the finance ministers of the EU recently agreed not to lower taxes on fuels in order to compensate for the increase in prices. If taxes were lowered it would increase oil demand thus preventing higher oil costs from leading to more efficient use of this energy source.

  In spite of the EU directives, some European governments have taken steps in this direction. In September, France announced a subsidy of 75 euros for home heating in the case of French households exempt from paying personal income tax. It is also planned to increase the deduction for kilometres travelled for work purposes in personal income tax which will come into force in 2007. A reduction in tax on agricultural fuels has also been announced. At the same time, in the case of transportation operators, with retroactive effect to January 1, 2005, there has been an increase in tax benefits for professional operators (a local tax) of up to 700 euros (previously 366 euros) and up to 1,000 euros, in the case of low consumption vehicles. Transportation contracts are to be modified to ensure they reflect the effect of fuel prices in invoiced prices. Belgium has also announced a series of similar measures to help families and transport operators.

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